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What Is A Line Of Credit?

What Is A Line Of Credit?

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What Is A Line Of Credit?

What Is A Line Of Credit?

A business line of credit provides small businesses with cash flow stability, an essential ingredient in ensuring the continuity of business, and the ability for the owner to pay critical expenses regardless of the business’s exact position in the working capital cycle. 

Businesses of all sizes make use of lines of credit in some form, all the way from 1-person operations to the largest corporations in the world. Read on to learn more about how to successfully use a line of credit to smooth out the peaks and valleys of free cash flow in your business.

How does a line of credit work?

Think of a line of credit like a credit card. Upon opening a line of credit with a bank or credit union, your business will have access to a quick source of funds. 

Lenders will often put in place a credit limit, also similar to a typical credit card. This credit limit depends on several factors, including the financial health of the business, potentially the personal creditworthiness of the business owner, and other factors at the discretion of the lending institution. 
The interest rate of a line of credit depends on the current prime rate plus a spread determined by the lender. This spread, in turn, depends on the credit score of the borrower. Businesses that have a high debt-to-equity ratio or low debt service coverage ratio will struggle to qualify for a reasonable interest rate.

Nevertheless, lines of credit offer businesses a flexible financing option which can help to even out the working capital cycle. For instance, a business that is short on cash, but needs to buy inventory or payroll, could use a line of credit to pay the supplier. 

There is no interest charged until there is an outstanding balance, but some banks will charge an annual fee or maintenance fee to keep the account open. After taking out a line of credit, monthly payments are made only on the amount borrowed. 

For very small businesses or newly established businesses, borrowers will need to have a good credit score and some lenders will also require collateral such as a home’s equity to secure a loan.

Secured vs. Unsecured Lines of Credit

Lines of credit typically come in two forms: a secured line of credit and an unsecured line of credit. 

Unsecured lines of credit do not require the borrower to put up collateral as security for the lender. These unsecured lines of credit constitute the most prevalent type of revolving financing for small businesses. Given that the lender has no security in the event of debtor default, an unsecured line of credit may have higher interest rates. 

Secured lines of credit, while less common than their unsecured counterparts, may offer benefits such as lower interest rates and fewer financial preconditions for the business to meet. Lenders can offer these types of lines of credit to less qualified businesses since the small business owner must put up collateral as a guarantee in the event that they cannot make their interest payments. 

Comparing Lines of Credit with Other Financing Options

While lines of credit often function as the first line of financial defense for businesses that have gaps in their cash flow, other financing options exist as well. 

These include traditional business loans such as term loans, SBA loans, working capital financing products, factoring services such as invoice factoring, business and consumer credit cards, and merchant cash advances among others. 

Traditional Business Loans

A conventional business loan comes in secured and unsecured varieties. The lending institution will provide a lump sum of cash in exchange for interest and principal repayments made on a periodic basis. The interest rate can depend on a multitude of factors, including the current demand for financing, macroeconomic factors, and the creditworthiness of the debtor. 

SBA Loans

A special type of small business loan, an SBA loan can act as a funding measure of “last resort” for businesses that have exhausted their other financing options. SBA loans come in several varieties, including microloans and loans for capital projects such as property, plant, and equipment.

Working Capital Financing

A working capital loan can come in several varieties, including factoring, term loans, and revolvers. These financing products can help businesses to make working capital payments such as wage expenses and inventory purchases. 

Factoring

For businesses with a large number of accounts receivable or expected future recurring payments from customers, a factor is an intermediary who provides upfront financing in exchange for accounts receivable or future recurring payments, which can help to smooth out cash flow problems.

Several types of factoring services exist, but the most commonly-seen variant revolves around services that pay businesses a lump sum less a fee based on a percentage of the overall value of the accounts receivable in exchange for those invoices.

Invoice factoring can help a business to tap into the latent cash in their accounts receivable to pay for critical expenses, including rent, supplies, wages, and more. Businesses considering this type of financing should weigh the pros and cons of giving up the full value of their future cash flows from customers. 

Credit Cards

Credit cards, both business credit cards, and consumer credit cards offer a high-interest financing option to businesses that need cash immediately. Credit cards often have high double-digit APR and other fees which make them challenging from a financial perspective to justify as a payment method for working capital requirements, but if the need is short-term, they can be an excellent option. 

Additionally, employees, landlords, and other types of stakeholders in the business will often not accept credit card payments. Taking a cash advance on a credit card account can cause a business to incur high fees in addition to less-than-optimal interest rates. 

Merchant Cash Advances

Financial firms which provide merchant cash advances sell these types of products by touting how they do not function as loans, strictly speaking. However, merchant cash advances carry with them very serious financial ramifications for any business.

Businesses that need upfront cash immediately can enter into a contract with a merchant cash advance provider whereby they receive a lump sum immediately in exchange for daily or weekly cash payments.

Merchant cash advances often carry very high fees based on a factoring rate. These fixed daily withdrawals can often put a business into dire financial straits if it cannot make the payments on time. 

You should consider other, less risky forms of financing before considering a merchant cash advance for your business. Businesses should generally start with low-risk forms of financing before descending into riskier financial products in order to fund the day-to-day business operations.

Acquiring a Line of Credit for Your Business

To begin the process of acquiring a business line of credit, first, do your research on the best banks and credit unions in your local market. Ideally, if you have a personal connection with a banker in your area, that relationship can serve as a starting point in your search.

Next, you will want to consider the benefits and drawbacks of different types of lines of credit. 

For example, one bank we surveyed offered several types of revolving credit facility, including a revolving line of credit, a cash flow management financing product, a business equity line of credit (which functions similarly to a home equity line of credit), and a business reserve line which functions as an overdraft protection product. 

After determining which product would benefit your business the most, you will then want to conduct your research on the best interest rate and payment terms your business can secure. 

Factors such as repayment flexibility, the repayment schedule, and the annual percentage rate will all play a role in your ultimate decision.

What Is A Line Of Credit?

What Is A Line Of Credit?

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